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Insides of financial analysis: Interpreting and inferring the financial statements

Insides of financial analysis: Interpreting and inferring the financial statements

The analysis of financial statements means identifying the financial strength and weakness of a business establishment by interpreting and inferring the financial statements of the establishment. These statements cannot be analysed by the mechanical method as a financial statement is designed to give the fair view, not accurate. A careful, patient and informed analysis is a must to ascertain qualitative appraisal of financial statements. Balance sheet and Profit and Loss accounts are two most important financial data available with an establishment. A balance-sheet informs us how a business stands at a particular point of a time. Comparison of figures of reporting period with previous years tells us the changes in the position of owner’s investment in the business year by year. It shows how the capital is distributed, how much of investment is identified with various accounts. The business trend can be examined by comparisons of various items in series of balance sheets that show changes in those items either increasing or decreasing. The successive increase of proportionate receivables to sales indicates that the company is the relaxed period of credit to the customers. Similarly, if creditors are increasing year by years means the company has earned the confidence of suppliers of materials for prompt payments for credit extended by them. It may also be inferred as the company’s inability to make payment to suppliers in time.

Profit and Loss statement sums up the results of operation till that time. It reveals the volume of sales for a given period of time. The total expenses and income and net profit earned after allowing for all the costs can be found out from Profit and Loss statement. By comparison of Profit & Loss statements with the corresponding period of previous years gives us the fair idea of increase or decrease in sales, increase or decrease in manufacturing cost, increase or decrease in overhead charges, financing charges etc. A careful study of the statement reveals whether the business was overstocked. If it is so, further investigation is required to find out whether an overstocked stock is due to accumulation of unsalable/obsolete stock.

How they are interlinked?

The figures in the income statement and balance sheet are interlinked. For examples, in a financial year, the earning of the company goes up and same is reflected in balance sheet increasing in net worth of the company. When higher provisions for income tax are made in expenses account, it would increase the level of current liabilities of the company at the balance sheet. The large operating and other expenses appearing in profit and loss account is linked to the higher amount of ‘accounts payable’ in the balance sheet ( possibly due to current assets purchased under credit). If the interest expenses of the company are high, it means the outside liability of the company is high because a high net worth company does not require to borrow at the cost of high-interest expenses. If the balance sheet is showing a large amount of fixed asset at the asset side of balance sheet, it is reflected in profit and loss account by way of higher nondepreciating expenses and the link between balance sheet and profit and loss account can be similarly established.

Audit report and Director’s report: Along with balance sheet and profit and loss accounts, the examination of Audit report and Director’s report are important to bankers. The auditor’s report reveals whether the company’s financial position and P&L a/c show a free and fair view of the state of affairs. Any unauthorised payments not connected with business or diversion of funds etc., if existed would be reported in auditor’s report. Any understatement/overstatement of liability or income would be reported/ qualified by the auditors. Under the manufacturing and other companies’ order 75, the auditor is required to make a statement on any matter that has a direct significance to the banker for monitoring the advance.

The Director’s report touches upon many important aspects of the working of the company and its prospects. More importantly, the director’s report is required to reply on every qualification appearing in the auditor’s report.

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Mr. Surendra Naik is a retired Chief Manager from Indian Overseas Bank and Founder, Chief Editor of www.bankingschool.co.in. He worked at IOB for three and half decades and specialized in Credit Appraisal & Forex.